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Monday, April 21, 2008

Paul Krugman Needs a Dose of the Julian Simon Cheer Up Elixir

Paul Krugman is concerned about the rising prices of commodities and their long-term economic implications:

[T]he global surge in commodity prices is reviving a question we haven’t heard much since the 1970s: Will limited supplies of natural resources pose an obstacle to future world economic growth?

How you answer this question depends largely on what you believe is driving the rise in resource prices. Broadly speaking, there are three competing views.

The first is that it’s mainly speculation — that investors, looking for high returns at a time of low interest rates, have piled into commodity futures, driving up prices. On this view, someday soon the bubble will burst and high resource prices will go the way of Pets.com.

The second view is that soaring resource prices do, in fact, have a basis in fundamentals — especially rapidly growing demand from newly meat-eating, car-driving Chinese — but that given time we’ll drill more wells, plant more acres, and increased supply will push prices right back down again.

The third view is that the era of cheap resources is over for good — that we’re running out of oil, running out of land to expand food production and generally running out of planet to exploit.

I find myself somewhere between the second and third views.

[...]

[R]ich countries will face steady pressure on their economies from rising resource prices, making it harder to raise their standard of living. And some poor countries will find themselves living dangerously close to the edge — or over it. Don’t look now, but the good times may have just stopped rolling.

Krugman needs to cheer up. Yes, soaring commodity prices are causing economic and political strains across the globe, but increased scarcity and the resulting higher prices are the mother of innovation. Higher prices in a market system send the signal--dare I say the profit motive--that there is a need to find new, more efficient ways to produce those goods and services that are sorely needed. This process can take time and there may be some market failure along the way, but by and large the advances humanity has made over the last few hundred years are a testament to how this process works.

Look at oil. Prior to the 1850s, sperm whale oil was the preferred fuel for lighting. However, sperm whales were and are a limited natural resource. Consequently, as sperm whale oil consumption increased, the sperm whale population decreased and the price of sperm whale oil shot up. Commodity prices were soaring and concerns were being aired about what we would call 'peak' sperm whale oil production. It was no coincidence then that around the 1850s people like Edwin Drake were looking for alternative energy sources. The price signal was screaming to entrepreneurs to "innovate...find new energy sources...high financial rewards to those who do" And so the petroleum industry took off and sperm whales were spared. I suspect the same is happening today to fossil fuels. There is increased petroleum scarcity given the growth of China et al. and the limited oil reserves in the world. As a consequence, the resulting high prices over time should lead to (1) increased efficiency with existing oil reserves (e.g. better mpg technology) or (2) alternative energy sources altogether. And this is just what the world needs in terms of pollution control and oil-influenced politics.

The key point is that this increased commodity scarcity should lead to new innovations that will, if anything, lead to higher standards of living in the future. Of course, all of this is not new. The late Julian Simon wrote about this process in his book "The Ultimate Resource II." Simon's argument is that human creativity when faced with increased scarcity is the ultimate resource. Don Boudreau has a nice discussion here on some of Simon's insights.

So, yes, Paul Krugman there are reasons to be hopeful. I would recommend a dose a day of the Julian Simon Cheer Up Elixir until your anxiety symptoms disappear.

P.S.Of course this entire discussion is premised on the notion that the run up in prices is due to fundamentals. There, of course, is an alternative explanation for the surge in prices: loose monetary policy and speculation. See Jim Hamilton for more.